Peritus was featured in the article “Why I Own HYLD” by Heather Bell in ETF.com’s “ETF Report,” September 2014, p. 26.
Tim Gramatovich, Chief Investment Officer of Peritus, was quoted in the article “Digging into Debt” by Asjylyn Loder, in Bloomberg Markets, October 2014.
Access to and pricing of energy in all forms matter immensely to consumers, markets and economies. Prices of electricity, gasoline, diesel and jet fuel are directly affected by oil prices and impact all consumers. We have seen the pricing on near month WTI oil futures contracts fall over the last month and during the past year. So does this have any real impact on our portfolios and does it change our thesis of higher oil prices in the future? Click here to see our update on the energy market.
As we have written about, historically speaking the high yield bond market has performed well during periods of rising rates (see our piece, “Strategies for Investing in a Rising Rate Environment”), due to the fact that the high yield market tends to have a lower duration than other fixed income asset classes, has a zero to negative correlation to Treasuries, and generally rates are rising during periods of improved economic environments, which is a positive for these credits. However we were recently asked if this time is it is different because of the historically low rates. We believe that the answer is both no and yes.
Generally speaking, we believe that the factors that have helped insulate the high yield market from higher rates in the past still are valid today—the relatively low duration and the fact rates generally increase during an improving economy. Addressing the latter first, we would expect that if the Fed does eventually raise rates, it would need to be on the back of an improving economy. We would expect that in order for a sizable increase in rates we would need to see an improvement in the economy off of where we are today, and we would expect those economic conditions would benefit corporate credit.
Turing to the relatively low duration, looking at duration levels over the past nearly 15 years, we see that current duration levels are certainly not elevated by historical standards.1
Duration is a measure of interest rate sensitivity, and takes into account yield. Though there are different ways of calculating duration, it is broadly defined as the effect a 100 bps (1.0%) change in interest rates would have on the price of a bond. One would think that if the currently low yields by historical standards were to dramatically change our interest rate sensitivity going forward, that would be reflected in the duration number. But as the graph above indicates, we are not seeing an elevation of duration.
However, on the flip side, we are seeing a portion of the market that is at very tight yields, so the usual benefit that a higher starting yield the can help cushion the rate change does not hold water for this segment of the market. The following chart depicts the issue.2
The highest rated piece of the high yield market, split BBB has a duration over 1 year longer than the next two highest ratings categories (BB/Split BB). Then once you get down to B rated securities and below, you are looking at about another year decline in duration. We see this split BB to split BBB portion of the index as trading more along the lines of investment grade, which does have a positive correlation to Treasuries and has historically performed well under that of the high yield market during periods of rising rates (though still a positive performance, see our blog “High Yield in a Rising Rate Environment: A Perspective on Historical Performance”). When we talk about tight yields, this highest rate portion of the high yield index exemplifies the issue, trading at a yield to worst of 3.81% for split BBB and 4.3% for BB rated bonds, bringing down the broader index statistics.
This is why active management within the high yield market is essential. Active managers are able to avoid the quasi-investment grade names that trade at very low yields and higher durations, the credits that we would expect to be much more impacted by interest rate increases, and take advantage of credits that are at seemingly attractive levels.
1 Modified duration for the Credit Suisse High Yield Index for the period of 1/31/2000 to 8/31/2014. The Credit Suisse High Yield Index is designed to mirror the investible universe of the $US-denominated high yield debt market.
2 Modified duration for the Credit Suisse High Yield Index based on the designated ratings categories as of 8/31/2014. The Credit Suisse High Yield Index is designed to mirror the investible universe of the $US-denominated high yield debt market.
Over the past several years we have seen a shift in high yield bond trading as exchange traded funds (ETFs) have grown to be a prominent force within the high yield market. While ETFs still represent a relatively small portion of the total $1.6 trillion market1, the index-based ETFs seem to have a disproportionate impact on the daily price movement we are seeing in the high yield space. This is especially true during the periods of large inflows or outflows within the high yield market.
It is important to keep in mind that the two biggest high yield ETFs have size constraints, whereby they are left to essentially invest in only a portion of the high yield market, while largely excluding issues that do not fit their size criteria. By their investment mandates per their respective underlying indexes, the SPDR Barclays High Yield Bond ETF (ticker JNK) has limited ability to invest in bond tranches below $500 million and iShares iBoxx $ High Yield Corporate Bond ETF (ticker HYG) has limited ability to invest in bond tranches below $400 million and from issuers with less than $1 billion of outstanding face value.2
So with this, we have seen a shift in focus toward the larger, “flow” names that fit the index size criteria. These large issue-size credits now tend to be more volatile, as the fast money moving in and out of the high yield space now seems to often be concentrated in these index-based ETFs. On days of heavy inflows, we often see upward swings in these underlying bonds and, alternatively, on days of outflows, we have seen notable downward pressure on these names.
Price action based on index inclusion has become a real factor in the high yield market, and we see it as an inefficiency within the market that can benefit active, unconstrained fixed income investors. For instance, as of YE 2013, high yield ETFs accounted for 11.9% of total retail high yield fund assets (mutual and exchange traded funds)3, but on weeks like the past week, we saw ETFs account for 58% of the weekly fund outflows4, which puts pressure on those large, “flow” bonds and can create buying opportunities for those not subject to fund outflows.
But above and beyond that, the biggest benefit we see from this size criteria inefficiency within the high yield market is the ability to purchase credits that do not meet this size criteria and are excluded based on their issue size. It is often in these smaller issue-sized credits that don’t meet the $500mm issue or $400mm issue/$1bil debt outstanding size requirements for inclusion in the passive funds, or credits overlooked by other large active vehicles that have massive mandates to fill and Wall Street sell-side research, that we find the best opportunity for value. We believe the ability to look where others can’t or don’t is a recipe for potential alpha generation. And in today’s market where so much focus is put on the tight yields, we see it as a way to find better yielding opportunities in underlying credits that we view as attractive.
1 Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update.” J.P. Morgan, North American High Yield and Leveraged Loan Research. April, 4, 2014, p. 43.
2 Fund restrictions sourced from the ETF prospectus and summary prospectus at https://www.spdrs.com/product/fund.seam?ticker=JNK and http://us.ishares.com/product_info/fund/overview/HYG.htm. Size limitation based on the underlying indexes for each fund. The fund may use a representative sample of the underlying index, which means it is not required to purchase all securities in the underlying index. Both funds may invest up to 20% of the portfolio in assets not in the underlying index.
3 Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2013 High Yield-Annual Review,” J.P. Morgan North American High Yield Research, December 23, 2013, p. 123.
4 Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update.” J.P. Morgan, North American High Yield and Leveraged Loan Research. September 12, 2014, p. 6.
The size of the U.S. dollar high yield bond and loan market is over $3 trillion,1 representing nearly 30% of the corporate credit markets.2
There is an incredible size and depth of these high yield bond and loan markets, yet for some reason, it still seems to be viewed as almost a throwaway allocation in portfolios. We would argue that these two asset classes should now be part of the new “core” of fixed income portfolios.
Historically “core” fixed income consisted of highly rated corporate bonds, government/agency securities and mortgages. Holding Treasuries as a hedge against systemic risk is something we can support and understand. Yet given the yields of today, how many investors are looking to build a core portfolio with these types of securities and yields of 2.25-3.25%?3
We would not view this as attractive and would expect many others would feel the same, yet many institutional investors seem to have ingrained in them to invest largely in these assets classes regardless of yield. We would view this as outdated thinking, as today’s high yield bond and floating rate loan markets bear little resemblance to those of 25 years ago, when the market was just starting, yet many investors believe them to be “high risk” asset classes.
The high yield and floating rate loan markets are large and growing markets, with what we see as attractive opportunities for active managers who are able to look for value and identify potential mis-priced securities. For a much more detailed analysis on risk and return we would ask investors read our “New Case for High Yield: A Guide to Understanding and Investing in the High Yield Market” and to learn more about our approach to the high yield market, see our piece “Peritus Investor’s Manual.”
1 High yield market size of $1,588 billion, Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update.” J.P. Morgan, North American High Yield and Leveraged Loan Research. April, 4, 2014, p. 43. The Leveraged Loan Market Size of $1,527 billion as of 3/31/14, Blau, Jonathan, James Esposito, and Daniyal Khan, “Leveraged Finance Strategy Weekly,” Credit Suisse Global Leveraged Finance, June 27, 2014, p. 25.
2 Total U.S. Corporate Debt market size (figures for fixed income asset classes other than high yield and leveraged loans) sourced from SIFMA, “Outstanding U.S. Bond Market Debt,” as of 3/31/14.
3 Barclays Capital U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt (source Barclays Capital). U.S. 5 Year Treasury Note is the on-the-run Treasury (source U.S. Treasury). Barclays Corporate Investment Grade Index consists of publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and the quality requirements (source Barclays Capital). Barclays Municipal Bond Index covers the long-term, tax-exempt bond market (source Barclays Capital). All data as of 9/11/14.
At Peritus we run actively managed portfolios of high yield debt. Our primary goal is to provide investors with a high current income, as well as the potential for capital appreciation. In addition to investing in the high yield bond market, we also look to the floating rate loan market and the equity market as we seek to generate this tangible yield for investors. Click here to read our “Investor’s Manual,” where we discuss our investment philosophy and current opportunities we see in today’s market.
We spoke last week about some of the reasons high yield bonds have historically performed well in rising rate environments, including the following:
- Higher coupons and yields in the high yield space help cushion the impact of rising interest rates.
- High yield bonds have shorter durations than other asset classes in the fixed income space.
- The prices of high yield bonds have historically been much more linked to credit quality than to interest rates.
- High yield bonds are negatively correlated with Treasuries.
Now let’s look at some actual numbers as to how high yield has historically performed in a rising rate environment. Since 1980, Treasury yields have increased (i.e., interest rates rose), in 15 of those years. In every one of those years, high yield has outperformed the investment grade market. The long-term numbers show that over those 15 years since 1980 where we saw Treasury yield increases (i.e., interest rates rose), high yield had an average return of 13.7% (or 10.4% if you exclude the massive performance in 2009). This compares to only a 4.5% average return (or 3.6% excluding 2009) for investment grade bonds over the same period.1
|Year||J.P. Morgan High Yield Bond Index Return||J.P. Morgan Investment Grade Corp Bond Index Return||Change in 5 Yr Treasury Yield|
So the data is clear that high yield has historically not only provided investors with solid returns during periods of rising interest rates, but has also dramatically out performed its investment grade counterpart. While we do not expect to see a rapid rise in rates (again see our blog from last week for our take on rates), we do believe that the high market provides a compelling fixed income opportunity for those concerned about rising rates.
For more on the high yield market’s historical performance during periods of rising rates and the current strategies in place, and their deficiencies, to address a potential rising rate environment, see our updated piece, “Strategies for Investing in a Rising Rate Environment.”
1 Data sourced from: Acciavatti, Peter Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2008 High Yield-Annual Review,” J.P. Morgan North American High Yield Research, December 2008, p. 113. “High-Yield Market Monitor,” J.P. Morgan, January 5, 2009, January 5, 2010, January 3, 2011, January 3, 2012, January 2, 2013 and January 2, 2014. 2008-2012 Treasury data sourced from Bloomberg (US Generic Govt 5 Yr), 2013 data from the Federal Reserve website. The J.P. Morgan High Yield bond index is designed to mirror the investible universe of US dollar high-yield corporate debt market, including domestic and international issues. The J.P. Morgan Investment Grade Corporate bond index represents the investment grade US dollar denominated corporate bond market, focusing on bullet maturities paying a non-zero coupon.
Over the last month, we have seen the equity markets hit all-time highs, all the while bond investors seem to be indicating there are reasons to be concerned, sending the 10-year Treasury to the lowest yields seen over the past year.1
So who’s right? We continue to hear constant chatter and concern in the financial media about rising rates on the horizon, but bond traders don’t seem to be indicating that is looming. We ended 2013 with virtually everyone (except us) expecting rates to rise in the year ahead as the long awaited “taper” began, yet so far in 2014 we certainly have not seen any rate pressure materialize as the Fed slowly decreases their asset purchases.
Headwinds for the “rising rate” argument seem to abound. Domestic unemployment and underemployment is still elevated, with much of the job gains being reported coming from temporary and part-time work. Global growth is moderate at best, with cracks starting to re-emerge in Europe, as we saw GDP in the three largest markets, Germany, Italy and France, contract for the second quarter…not to mention the outlook isn’t any rosier given the tensions with Russia. And with our 10-year government bond rates at 2.4% versus those of 0.5% in Japan, 0.93% in German, 1.3% in France, and 2.4% in Italy2, our bonds seemingly do look like a good buy. Not to mention the demographic overhangs (see our piece “Of Elephants and Rates”), with pension plans focused on liability driven investing (LDI) and retirees needing income, creating what we see as a sustainable, longer-term demand for fixed income products. It is also important to keep in mind that if and when the Fed starts to raise “rates,” we are talking about the Federal Funds Rate which we expect will primarily impact the short end of the yield curve, and much less so those 5-year, 10-year and longer maturities.
But for the sake of argument, let’s assume that rates do rise from here. What does that mean for the high yield market? The traditional thought is that as interest rates rise, bond prices fall. But looking at history, the high yield market has defied this widely held notion. Let’s examine the four main reasons why high yield bonds have historically performed well during times of rising interest rates.
Higher coupons and yields in the high yield space help cushion the impact of rising interest rates. High yield bonds, as the name would suggest, have traditionally offered among the highest coupons/yields of various fixed income instruments, corresponding to higher perceived risk. The following chart depicts current yields, coupons, and the spread over Treasuries for several fixed income asset classes.3
Let’s think about this intuitively for a minute. If you own a bond with a yield of 3% and interest rates move up 1% that would obviously have a meaningful impact, as we are talking about move equivalent to 33% of your total yield. However, if you instead have a starting yield of 6.0% on a bond and interest rates move that same 1%, you are looking at a significantly less impact. So the higher the yield, the less the interest rate sensitive the bond per the duration calculation that we discuss below and the more income is being generated to offset any impact from a bond price response to the interest rate move.
High yield bonds have shorter durations than other asset classes in the fixed income space. Duration is a measure of sensitivity to changes in interest rates that incorporates the coupon, maturity date, and call features of a bond. The fact that high yield bonds are typically issued with five to ten year maturities and are generally callable after the first few years, as well as offer higher coupons, typically provides the high yield sector with a shorter duration, thus theoretically less interest rate sensitivity, versus other asset classes. We’ve profiled some duration comparisons below:4
The prices of high yield bonds have historically been much more linked to credit quality than to interest rates. Historically, interest rates are increasing during a strengthening economy and a strong economy is generally favorable for corporate credit and equities alike. Due to the nature of the high yield bond market, the major risk on the minds of investors is default risk (not interest rate risk), causing them to be much more concerned with the company’s fundamentals and credit quality than interest rates. When the economy is expanding, profitability, financial strength, and credit metrics often improve as well. So a stronger economy would undoubtedly be a positive from a credit perspective and would indicate lower default rates, meaning likely improved prospects for the high yield market.
Even in today’s environment of low to moderate economic growth, we are still seeing solid fundamentals for corporations and a well below average default outlook for the next couple years5:
High yield bonds are negatively correlated with Treasuries. This means that as Treasury prices go down due to yields (interest rates) increasing, high yield would theoretically experience the opposite change (increase) in pricing. Additionally, while high yield is still positively correlated to investment grade, it is a fairly low correlation; yet, we see a strong correlation between investment grade and Treasuries. As noted below, over the past 15 years, high-yield bonds and loans exhibit correlations to the 10-year Treasury bond of -0.21 and -0.38, respectively, versus a far higher correlation of +0.62 for high-grade bonds.6
Given these low or negative Treasury correlations versus other asset classes, especially the more interest rate sensitive asset classes such as investment grade, an allocation to high yield bonds can help serve to improve portfolio diversification and potentially lower risk depending on the mix of assets. On the flip side, an allocation to investment grade not only provides you a much lower starting yield but can result in significantly more interest rate sensitivity.
In short, while we don’t see a spike in rates on the horizon, even if your take is that they will rise, we believe that the general high yield market is positioned well. Within this asset class, we feel the real opportunity for investors is in actively managed portfolios, where managers can avoid overly valued securities and focus on yield generation. For more on the high yield market’s historical performance during periods of rising rates and the current strategies in place, and their deficiencies, to address a potential rising rate environment, see our updated piece, “Strategies for Investing in a Rising Rate Environment.”
1 Data sourced from Bloomberg and U.S. Treasury, Daily Treasury Yield Curve Rates as of 8/29/14.
2 Data sourced from Bloomberg as of 9/2/14.
3 Barclays Capital U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt (source Barclays Capital). U.S. 5 Year Treasury Note is the on-the-run Treasury (source Bloomberg). Barclays Corporate Investment Grade Index consists of publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and the quality requirements (source Barclays Capital). Barclays Municipal Bond Index covers the long-term, tax-exempt bond market (source Barclays Capital). All data as of 7/28/14. The yield to worst is the lowest potential yield that can be received on a bond, without the issuer actually defaulting, and includes the various prepayment options such as call or sinking fund. The spread is the spread to worst based on the yield to worst less the yield on comparable maturity Treasuries. The coupon is the annual interest rate on a bond.
4 Barclays Capital U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt (source Barclays Capital). U.S. 5 Year Treasury Note is the on-the-run Treasury (source Bloomberg). Barclays Corporate Investment Grade Index consists of publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and the quality requirements (source Barclays Capital). Barclays Municipal Bond Index covers the long-term, tax-exempt bond market (source Barclays Capital). All data as of 7/28/14. The Modified Adjusted Duration is a measure of interest rate sensitivity based on the yield to maturity date.
5 Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield and Leveraged Loan Research, June 20, 2014, p. 12. 2014 default rates exclude TXU.
6 Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2013 High Yield-Annual Review,” J.P. Morgan North American High Yield Research, December 23, 2013, p. 296.
We ended 2013 with virtually everyone (except us) expecting rates to rise in the year ahead as the long awaited “taper” began. Well, so far in 2014 we certainly have not seen any rate pressure materialize as the Fed slowly decreases their asset purchases. With unemployment and underemployment still elevated, very moderate global growth, demographic headwinds, and the Fed explicitly clear in extending their low interest rate policy for a “considerable time” once their asset purchases have been eliminated presumably by the fall of this year, it is unclear that a rapid rise in rates is on the horizon. But for the sake of argument, let’s assume that rates do rise from here. What does that mean for the high yield market and the various “strategies” out there to deal with rising rates? Click here to read our recent piece “Strategies for Investing in a Rising Rate Environment.”